What is a tax credit?

A tax credit is defined as an amount that reduces total tax liability dollar for dollar. This means that if a taxpayer qualifies for a tax credit, the amount of the credit is directly subtracted from the taxes owed. For example, if a taxpayer has a $1,000 tax liability and qualifies for a $200 tax credit, their new tax liability would be $800. This provides a direct benefit to the taxpayer by lowering the amount of tax they need to pay.

In contrast, other options describe concepts that do not align with the definition of a tax credit. An increase in taxable income, non-taxable percentages of income, or amounts added to taxable income do not provide the direct benefit associated with a tax credit. Understanding the mechanisms of tax credits is essential for tax planning and can lead to significant savings on an individual’s tax bill.